Northrop Grumman recently joined forces with Lockheed Martin (LMT) to pursue upcoming opportunities for Distributed Common Ground Systems (DCGS). Northrop is expected to take the lead in pursuing near-term Army and Navy business, while Lockheed Martin will lead the pursuit for near-term Air Force Block 20 business.

Furthermore, there is a contract with the United Kingdom's Royal Air Force for NOC to apply its supply-chain management expertise.

The potentially negative case against the company is based primarily on the risk of declining defense spending. Northrop is tied to an estimated $1 billion per year in missile-defense related programs. In addition, Northrop has a history of inconsistent financial performance.

UPS Undervalued

We are continuing our Buy on United Parcel Service, Inc. (UPS), as the stock is undervalued, but cutting our target price to $75. UPS reported second quarter EPS of $0.85, in line with earnings guidance provided on June 23. We are decreasing our EPS estimates for 2008 to $3.60 from $4.05, the midpoint of the company's revised EPS guidance of $3.50 to $3.70, reduced from $3.90 to $4.20, and to $4.15 from $4.65 for 2009.

While the weaker U.S. economy, slowing US volume growth, the shift away from premium products, increased fuel costs and higher interest expenses related to a $6.1-billion pension payment will be earnings drags, rate hikes, expansion into China, recent acquisitions, and share repurchases should propel EPS growth. In January, UPS instituted a two-year, $10-billion share repurchase plan and announced a 7% increase in the dividend.

United Parcel is also expanding its base in China and it intends to invest $100 million in a joint venture with the Sinotrans Group, one of China's largest parcel operations. As a result, UPS will become the first foreign company to have a wholly owned operation in the express parcel business in China. We view this as a significant investment positive, as it provides access to 330 cities, which account for nearly 85% of China's gross domestic product.

At its current price, UPS is trading at substantial premiums to the peer group based on price/sales and price/book value. Superior operating efficiency, balance sheet strength and ROE justify a premium valuation to the peer group. Therefore, we expect valuation to expand from currents levels.

Target $78 for CAT

Caterpillar Inc. (CAT) reported second quarter EPS of $1.74, above our expectations of $1.52, due to a lower share count, increased price realization, and higher International sales volume. The company remains committed to capacity expansion in growth markets outside the U.S, which positions CAT to increase share in mining and energy-related equipment.

Our FY08 EPS estimate of $6.41- which is above the management's guidance - assumes 30% revenue growth in the Middle East, Asia Pacific, Latin America, no growth in North America and a share count of 608 million. Our target price is $78.00.

For the remainder of 2008, we expect commodity prices to be at a level high enough to sustain additional purchases of mining & energy-related equipment. Improved price realization of $398 million offset the $143 million increase in manufacturing costs and the $113 million increase in SG&A and R&D.

As a result of a continued share buyback program, the company lowered its (y-o-y) diluted share count to 636 million from 663 million. The lower (y-o-y) share count added approximately $0.07 to second quarter EPS. At the end of June 30, CAT still had $4.4 billion left on its current buyback program. We expect the share buyback to be funded through operating cash flow generation. Our FY08 share count assumption is 608 million (diluted) shares outstanding. The company expects 2008 revenue to increase to approximately $50 billion, which is revenue growth of 11.3%.

For 2009, we are turning cautious on global growth, commodity prices, commodity-related equipment spending and currency translation gains. We are less favorable on the prospects for international growth as global central bankers increase interest rates to fight inflation.